After a decade of 'tough sledding,' dividend reinvestment could once again become a major driver of total returns
While the past decade has been a historically difficult period to execute a dividend income strategy, one portfolio manager says the shifting economic regime of high inflation and rising interest rates could mark a turning point.
“In most developed markets reinvested dividends have accounted for between 40% and 50% of total returns going back over 100 years,” said Darren McKiernan, Senior Vice President and Head of Global Equity & Income at Mackenzie Investments. “But for the last 10 years from 2010 until 2020, dividend reinvestment has accounted for just around 15% of total returns. Around two thirds of total returns over that time has come from multiple expansion.”
Recent conditions in the markets, McKiernan says, have been warped compared to longer-term history by near-zero interest rates. But as the world turns toward a more normal regime of economic cycles happening more naturally outside the dictates of central banks, he believes the odds will be more tilted toward dividend-focused investors.
The deteriorating macro backdrop of inflation and rising rates could also prove relatively favourable for dividend strategies, McKiernan says, which have a decent record of delivering reasonable returns in challenging environments like today. Having exposure to dividend-payers with a proven record of increasing payouts over time, he adds, provides valuable defence in a reality where time whittles away at purchasing power.
“We think that’s a much better place to be in as an investor than owning a 10-year Canada bond with a 2.5% or 2.6% yield,” McKiernan says. “That coupon isn’t growing, and even though you’re guaranteed to get your principal back, it won’t be worth nearly as much in 10 years if we have inflation at 2%, 3%, or 4% every year.”
Dividend-paying companies, like other income strategies, typically provide better downside protection than non-dividend payers, and also help reduce portfolio volatility because of the coupon attached to them. So while the most recent decade has been among the worst ever for dividend investors, McKiernan sees hints of a breaking dawn for those who have stood by the strategy.
“As somebody who's been running a dividend fund since 2009, I can honestly say it's been tough sledding. We've done a decent job of keeping up, and I’m very proud of our team for that,” he says. “But looking at some of those high-level numbers, I think we could be coming into a much more conducive environment for dividend investing than we have in the previous 10 years.”
A whole swath of the portfolio is exposed to companies with high margin structures, which is a critical advantage in an inflationary environment.
As an example, McKiernan points to the fund’s healthcare industry investments: he estimates they have gross profit margins of 80% on average, and a 10% increase in their cost of goods sold due to inflation would lower their operating income by about 5%. In contrast, a company with a 20% gross profit margin could expect to see a 60% decrease in its operating income for every 10% increase in its COGS.
“On the consumer side, you might want to own a company like Diageo, which owns Johnnie Walker scotch, where costs were accrued many years in the past when they put their stock in the barrel. Restaurant companies like McDonald’s or Domino’s Pizza that operate a franchise model, where they take a slice of revenues from the stores, stand to benefit from inflation as prices go up,” he says. “The average operating margin in our portfolio today is over 30%, and that compares to our benchmark that’s in the mid- to high teens.”
Beyond that, McKiernan says the team behind Mackenzie Global Dividend Fund puts a particular focus on industries where companies are not investing in capacity additions to their operations.
The current poster child for that category, he says, is energy. Even as the Russia-Ukraine conflict helped exacerbate a global oil shortage, sending prices soaring past $120 a barrel, demand for oil remained strong thanks to global appetite for travel as economies exit the pandemic. More remarkably, energy producers still did not make investments to accelerate their plans for production.
“Even at $125 oil, not one major oil company that we own or follow announced significant CapEx plans beyond just maintaining their current production growth. They're just keeping their production growth steady with services inflation,” he says. “In contrast to the commodity boom of the mid-2000s, when people were putting their free cash into the ground, they’re raising their dividends and buying back shares heavily.”
